Is there a chill in the air?

Most analysts agree the red hot growth of the U.S. economy witnessed in the first half of the year is cooling off; housing and manufacturing reports back this up. For instance, in early June U.S. factory activity gains slowed and the real estate market experienced a drop in construction spending. While there is a consensus that the U.S. economy will not grow at the 5.3% annual rate seen in the first quarter, opinions differ on just how cool, or even cold, the U.S. economy will get.

Take the National Association for Business Economics’ (NABE) forecast for example. The NABE panel is calling for “a period of slightly below-trend growth with moderate inflation for the rest of this year and next.” The panel’s outlook states that on a fourth quarter-over-quarter basis, real GDP growth in 2006 is expected at 3.5%. They expect real GDP growth to average 3.1% for the next seven quarters along with core CPI inflation stabilizing near 2.3%. Mike Englund, chief economist with Action Economics and a NABE panelist, says, “We expect GDP to drop to a sustainable path from 4% to a 3.5% GDP.”

However, Brian Bethune, U.S. economist with Global Insight, pegs GDP growth slightly lower as the year progresses. “We expect 3.6% for the second quarter, 2.6% for the third quarter and 2.4% for the fourth quarter,” explaining that his firm forecasts a greater drag in early 2007.

Yet other predictions are even less rosy. Barry Ritholtz, chief investment officer with Ritholtz Capital Partners, explains, “By the end of the year if GDP is above 2% we are lucky. By real standards, we would be crazy to think that the economy in 2005 experienced any quarter over 2%.” Ritholtz says by real standards the first quarter in 2006 should have been closer to 3.5%. He sees the second quarter coming in around 3%, the third and fourth quarter around 2.0% to 2.5%, and expects we could be seeing a flat 0% GDP or worse by the first or second quarter of 2007. “We had a decent first half to the year, but the second half will be pretty ugly,” Ritholtz says, pointing to a cooling real estate market as one of the key drivers.

While Ritholtz forecasts may seem grim, he reminds us that markets run in cycles and this one, like every other, will not last forever. “But there are bad things in the economy that we have been ignoring for years and do eventually have to come to roost,” he says. Ritholtz explains that from a macro viewpoint stimulus that has been driving the economy include interest rate drops, tremendous amounts of dollars in print, increases in deficit spending and large tax cuts. “But this works as a stimulus up to a point and then the stimulus fades,” he explains. “One of the most important rules of economics is that there is no free lunch. There are negative repercussions, such as inflation from ultra low rates,” he says, adding, “If you really want to know about inflation, just ask a housewife or a taxi cab driver.”

Like Ritholtz, Steve Ricchiuto, chief U.S. economist with ABN Amro, also looks to the real estate market as a major indicator for the economy’s near term direction. “Our macro forecast is that the economy will head into a slower growth path over the balance of this year because of the deceleration of the housing market,” Ricchiuto says.

HOUSING RULES

So just how much cooling do analysts expect from the housing market for the remainder of the year? “We predict a gradual downward adjustment in the housing market,” Bethune says. And not much of a surprise is expected from Englund as well. “We expect to continue to see cooling in the housing market, with working our way back toward trend growth. We will still continue to see some markets overshot and some undershot,” he says. However, some analysts reveal forecasts that are a little more upbeat for the ever important real estate market. “As for the housing market, yes we have seen an increase in unsold inventory and growth has slowed down, but prices haven’t really dropped and mortgage rates by historical standards are still low,” says Robert Dubil, chief economist with HedgeStreet. “Actually you could say I am bullish on the housing market. We will still see a trend to build second houses, just not at the pace seen in the last couple of years,” Dubil says.

Nevertheless, the question remains, will the recent less-than-merry housing and manufacturing reports be enough to take the Fed off its tightening path? After all, the Fed itself has said the timing of any future rate hikes would be heavily dependent on incoming economic data. However, minutes of the May Fed meeting revealed that faster inflation could lead to another rate hike. Overall, opinions on exactly where the Fed will pause differ quite widely. The NABE panel, for instance, predicted the 25-basis point increase to 5%, which occurred in May, will be where the rates stay for the remainder of the year.

On the other hand, Bethnune in late May said, “We are looking for another 25-basis points on June 29. The number of rate adjustments will be fairly limited. We expect one, maybe two more before the end of the year, putting rates in the 5.5% range.” Bethune points to moderate upward pressure on core inflation as the main driver for continued rate increases. “However, this is not a systemic problem. We expect to see upward pressure through early 2007 and then to see it moderate after that.” Ricchiuto also sees more rate hikes yet this year. “I still think it is possible we will pause in June, but it won’t be permanent. The Fed could come back in August and then implement a 50-point basis point increase,” he says. “I still think 6% is out there, but I am hopeful it will be in 2007 and not in 2006.” And Ritholtz is not ruling out the 6% mark either. “By the end of the year, interest rates will end up between 5.5% and 6%,” he says, adding, “Not a great place for stocks.”

ONE FOR THE BEARS

Even a 5% Fed funds rates proved to be a rotten place for equities. Stocks were hit extremely hard in May because of fears of inflation, slow economic growth and the biggest scare: more rate hikes. These fears led the S&P 500 index to fall 3.1%, placing the index at its worst month in 22 years. On May 17, stock indexes plunged when a stronger than expected increase in consumer inflation fueled fears that interest rates would increase. The Dow dropped more than 200 points at one point during the day. Other volatile moves followed, including May 30, when higher oil prices, sliding consumer confidence and a weaker than expected sales report from Wal-Mart Stores Inc. sent the Dow skidding almost 185 points. As for the year, at the end of May the S&P 500 was up 1.8%, the Dow was up 4.2% and the Nasdaq was down 1.2%.

So the question is, will this volatility continue? Some analysts seem to think it is going nowhere fast. “As for a macro outlook, we see a return to higher volatility,” Ricchiuto says. “Volatility will dominate the outlook for the markets over the summer.” As for a stock market forecast, Ricchiuto sees the market in the near term popping to 12,900 with a correction through 12,040 and 12,050, which he says could get the market down to a window of 11,040, followed by a correction back up to 13,050 by the end of the year.

Most analysts point to interest rate uncertainty fueling the volatility. And many say that once this uncertainty passes, the market will do a better job of finding some footing. “The global economy will continue to expand in 2006 and 2007. We will see some good stimulus. But for now uncertainty about interest rates will keep things on a sideways track,” says Bethune, adding that a strong outlook for business investments and business structures is imbedded in his firm’s forecast for the Fed’s success in a soft landing.

However, Dubil is forecasting that the normal summer doldrums will eventually take hold of the equity market. “We will continue the next few months with little volatility and traders and investors will have an opportunity to see gains in the third and fourth quarter,” Dubil says.

Regarding specific market sectors, Ritholtz points out, “Consumer staples are starting to move up, which is a defensive sector. I see this sector starting to attract some money along with bonds.”

OIL’S PULL

Of course another major piece of the puzzle for stocks and the future of interest rates is the price of energies. According to Dubil, the price of oil will play a large role in the Fed’s future moves. “I don’t think the Fed is done yet, I still see an inflation threat from energy prices,” Dubil said in late May. “The Fed has one or two more moves left.” And just where will oil land in the near term? Ritholtz comments, “Oil will probably be $50 to $80 [per barrel] in the foreseeable future.” Some analysts say Mother Nature will have a lot to do with the answer.

“With oil’s demand remaining strong and supply growth limited, prices will stay elevated in the high $60s, probably around $67 to $68 for the remainder of the year,” Bethune says. “However, the wild card is the hurricane season. The weather association is predicting another above-average hurricane season.”

So in a nutshell, all eyes are on Federal Reserve Chairman Ben Bernanke and the Fed’s next moves. Energy prices, stocks, the dollar and numerous other economic factors will feel the effects of the Fed’s decision to pause or not to pause.

“We take the risk that Bernanke will undertighten or overtighten,” Ricchiuto explains, adding that while the markets would allow Alan Greenspan to fight one side, because Bernanke is the new chairman who hasn’t had the chance yet to prove himself, the markets are not as forgiving. So the question becomes, according to Ricchiuto and probably many other investors: Can Bernanke pull a monkey out of his hat that will increase his credibility and bring volatility back to lower levels?” Maybe the best answer at this point is to stay tuned.